Is US in a Liquidity Trap?

Explaining the crises (not all, but many of them) as being liquidity traps is not only a misinterpretation but it also leads to false solutions. Just look at the case of Japan after two decades of “policy experiments”. (New) Keynesians like Krugman have reduced its stagnation problem to a liquidity trap and prescribed a wrong therapy which in the end failed to lead to real economic growth. But probably the case of Japan deserves a separate discussion.

Let us turn to the current problems in US. But you might have guessed until now: Krugman discovered again a liquidity trap. According to him, this implies that the “current” monetary policy is “ineffective”. However, one that would change the expectations of investors would be effective.

Fortunately, not all economists agree with this position. Even some of those believing in the liquidity trap idea do not share all his opinions. Take a look at the discussion here by David Andolfatto. He basically rejects Krugman’s assertion that the supposed liquidity trap is due to “insufficient private demand”.

Stephen Williamson also departs from Krugman’s view by considering that we are not in a classical liquidity trap (in his words, Grandma’s liquidity trap). This implies that the current interest rate is not too high (as in the classical liquidity trap), but too low. This also implies that “more” traditional approaches like increasing the inflation target would not work. But what is more interesting is that Andolfatto sees the current low real interests rates as due to the problems in the real economy.

However, not all today economists are (New) Keynesians. A refreshing critique of this evaluation of US being in a liquidity trap can be found on John Cochrane’s blog. His article is a useful discussion of the liquidity trap in New Keynesian models based on the presentation in Ivan Werning’s paper.